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We are very pleased to announce that Erik Nelson, President of Coral Capital Partners recently had the following article published on the Fall 2011 edition of Micro-Cap Review Magazine. We have reprinted the article below for your reading, and a printer friendly copy is available here.

Performing Due Diligence on a Micro-Cap Oil & Gas Company

By Erik S. Nelson

It seams like everywhere you turn there is someone touting a new start up oil & gas company or a drilling program with a set of oil leases. Over the last several years Coral Capital Partners has evaluated and performed due diligence on countless oil & gas companies, and leases. With so many investors giving consideration to investing in these small and micro-cap oil & gas companies I thought now would be a good time to discuss what I look for when I am evaluating these projects for Coral’s clients

When conducting due diligence or evaluating an oil & gas company it is very useful to understand several key items and terms.

Working Interest (WI): This is the percentage ownership of the lease that the company has the right to drill, produce, and operate as well as share in all the costs associated with the lease activity. I typically like to see a company with a solid majority Working Interest percentage. In my book, the closer to 100% the better. I do not like to see a company with a minority Working Interest position.

Net Revenue Interest (NRI): This is the percent of revenue that the working interest holders keep after paying the royalties to the owners of the mineral rights and all other non-operating interests. In the past it was typical for the owner of the mineral rights to keep a one eighth, or 12.5% Net Revenue Interest. This meant the holders of 100% of the working interest had an 87.5% Net Revenue Interest. With the current high price of oil the owners of the mineral rights are able to keep a higher percentage than in the past and as a result an 82.5% to 80% Net Revenue Interest is much more common. I would look to avoid any companies that have less than 80% NRI on their oil leases.

Field Operations: Most small companies do not operate their own fields. What is important to know is if operating costs on a per well basis are relatively low. There is an old saying in the oil and gas industry about a field being operated to death; basically you want to make sure that the operating expenses are not going to eat up all the profits from the oil and gas production.

Decline Curve: This is an important one. Every well will see a decline from its initial production within a reasonably short period of time. What is important is where the well production stabilizes. For example if a company drills a well and the initial production is 25 barrels of oil per day, but a month later the well’s production has declined and stabilized at 10 barrels of oil per day, then you would value the well based upon the stabilized 10 barrels of oil per day. You cannot expect to produce an accurate valuation on the oil field if you do not know what to expect for long term production.

Reserve Report: This is a report produced by a geological engineering firm that attempts to estimate the total amount of oil or gas in place, how much of it is recoverable and over what length of time. Typically a reserve report will attempt to provide an estimate of the net present value of this production. The typical discount rate is 10%, and thus you will tend to see a lot of discussions concerning NPV(10), which is the value today of the cash flows at an interest rate of 10%.

Production Records: Every state requires a certain level of reporting on the production from each and every well. Any company that is evaluating a lease with prior production should have copies of these production records. They become important when a company is attempting to evaluate a lease for purchase. Without these records it is very tough to get an estimate on the value of a field. When looking at a private project, if they don’t have the past production records then I would probably pass on the project.

Proven Oil & Gas Reserves: Oil and Gas reserves for which there is at least a 90% confidence of their being able to be recovered under favorable economic conditions.

Proven Developed Reserves (PD): Proven developed reserves are those where there are existing wells, that may or many not be in production, where minimal additional investment is required in order to recover the oil and gas in place.

Proven Developed Producing Reserves (PDP): Proven developed producing reserves are reserves where there are existing wells in production that are capable of recovering the oil and gas that is in place.

Proven Undeveloped Reserves (PUD): Proven undeveloped reserves require additional capital investment, most typically the drilling of additional wells in order to recover the oil and gas that is in place.

Production Stimulation: Currently most companies in the oil and gas industry are either drilling into shale formations with a very high probability of success or they are reworking old fields in order to increase production. This can be a low risk and very smart way to build a company; but it is also important to have an understanding what the plans are to increase the production on an existing field. One of the most basic ways of increasing production is to rework the wells. Many times this will involve replacing equipment and sometimes even re-boring the well. If done properly this can be a cost effective way of boosting production. It is important to know what the company’s plans are and how it controls the cost associated with these plans.

Water flooding is when a company pumps water down an old well in an attempt to pressurize the field and in the process push the oil that remains underground towards the production wells. This is a proven and highly successful technique. However, the drawback associated with this is that the oil produced typically comes to the surface with a fair amount of water mixed in, which needs to be separated and properly disposed. This can dramatically up the costs associated with operating a field.

A more advanced method of pressurizing a field involves injecting a gas into the field. The most common gasses used in injection stimulation are either carbon dioxide or nitrogen. Carbon dioxide is a more abundant and cheaper gas to use, however it can react underground to form carbonic acid which can be highly corrosive to the equipment in the oil field. Nitrogen is slightly more expensive to use, but it generates better results and doesn’t form acidic compounds that eat up the equipment. When I am evaluating oil field stimulation I prefer to see either a form of nitrogen or carbon dioxide stimulation.

Management: This is a key item for any company, in any industry. It is critically important in the oil and gas industry which has had a habit of attracting bad actors throughout its history. When I am evaluating an oil and gas company I take a close look at the management of the company. Not only do I read the SEC filings and look at the material the company is supplying, but I also conduct my own research on the internet. I do a variety of searches on the management teams and the board of directors of the company. I look to see how their past projects have performed, and I look to see if they have had any regulatory problems in the past.

Another thing I feel it is important to review is the ownership of the company. Does the current management own a meaningful stake in the company? I also look to see if any of the major shareholders are corporation or limited liability companies. This is important as a lot of bad actors like to hide their ownership through limited liability companies (LLC). When I see a LLC with a significant ownership position I will do research on the company and who the principals are behind the company. If I find any regulatory problems or “red flags” regarding the board of directors or management, I am gone, there is no way I would consider an investment.

Structure: I believe in simple, clean corporate structures. I like to see a single class of common shares, and at most a few different classes of preferred. What I do not like to see is convertible debt or preferred that doesn’t have a hard floor to the conversion price. I also do not like to see project overrides to management or board members; I feel this creates a conflict of interest that places their interest above those of the shareholders.

Hopefully you will find the above information useful and helpful. Proper due diligence on a project does not guarantee a successful investment; but it can go a long way towards making sure that you avoid undesirable companies and place your hard earned investment capital in a company with a good chance of succeeding.

About Coral Capital Partners

Coral Capital Partners is an independent consulting and advisory firm focused on companies and participants in the lower and middle markets. We partner with our clients to provide cost effective solutions to real world issues and situations. Our experienced team brings a diverse set of skills that allows us to service a wide variety of needs. Our area of services and expertise focuses on bringing services and solutions to our clients that are normally only available to much larger firms.

Coral Capital Partners, Inc. provides services to Investment Banks, Private Equity Funds, investors, and both privately held and publicly traded companies, as well as various stakeholders in those organizations. This has included international public companies with operations on three (3) continents to smaller privately held domestic companies.

Our experience in the areas of corporate advisory, due diligence reviews, and regulatory compliance allows for a cost effective and efficient solution to the issues at hand. Please feel free to contact our offices to see how we may be of assistance.